Theoretical Economics, Volume 8, Number 3 (September 2013)

Fragility of reputation and clustering of risk-taking

Guillermo L. Ordoñez

Abstract

Reputation concerns in credit markets restrain borrowers' temptations to take excessive risk. The strength of these concerns depends on the behavior of other borrowers, rendering the reputational discipline fragile and subject to breakdowns without obvious changes in economic fundamentals. Furthermore, at an aggregate level, breakdowns are clustered among borrowers with intermediate and good reputations, magnifying otherwise small economic shocks.